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Peloton: The Right Mix Of Addictive Ingredients

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About: Peloton Interactive, Inc. (PTON)
by: Vishesh Raisinghani
Summary

Peloton seems to be creating an ecosystem with intense user stickiness.

Peloton’s valuation boils down to a few factors - substantial gross margins, subscriber retention and eventual profitability.

Taking moderate growth and risk into account, the stock seems fairly valued at the moment.

All business models lie on a spectrum between want and need. If you have a life-threatening disease, you need a certain drug and you’ll buy it regardless of whether you want to. On the other hand, when a luxury car maker announces the latest model, you certainly want it, but it’s arguable whether you need it.

Companies on either end of that spectrum can create some truly lucrative business models. But companies in the middle, where the product is neither necessary nor desired, struggle. That’s where the fitness industry is.

Don’t get me wrong - exercise is a must. Everyone needs a minimum amount of physical activity each week. However, you can get that activity for free by running, skipping or doing push-ups. You can probably learn to do yoga or eat right by watching a few YouTube videos.

Couple that with the fact that most people simply don’t want or can’t get themselves to exercise and you can see why the fitness industry is such a nightmare for entrepreneurs. However, a handful of business have been successful by picking one of the following strategies:

  • Lock up money: The model your local gym follows when it offers an annual subscription.

  • Create a trendy brand: The model favored by brands like Nike (NYSE:NKE) and Lululemon (NASDAQ:LULU).

  • Inject network effects: Peer pressure powers SoulCycle (SOULC), Crossfit and Strava.

  • Make it easy: Offer convenience by opening more branches and keeping them open around the clock like Anytime Fitness.

All of these strategies seem to work. The companies mentioned above seem to have steady growth, healthy margins and recurring income streams. But what if you were trying to combine all these strategies to create a vertically-integrated fitness juggernaut? The company you’d end up with might look something like the recently-public Peloton (PTON).

The right mix of ingredients

By combining each of the four strategies I’ve mentioned above, Peloton seems to be creating an ecosystem with intense user stickiness. The company offers a limited lineup of expensive products, invests heavily in marketing to reinforce the ‘premium’ brand, compels buyers to buy its monthly subscription for classes and uses streaming and social media-like features to make users feel part of a group.

This strategy isn’t particularly new or unique. In fact, the largest tech companies in the world are all currently attempting a similar ‘device sale/ongoing subscription’ model. Think of the iPad/Apple TV+ (NASDAQ:AAPL), Amazon (AMZN) Firestick/Prime Video and Facebook’s (FB) Oculus/Horizon combinations. What sets Peloton apart is the fact that it is successfully selling the devices at a profit and seems to be getting the social aspect right.

The company’s product lineup includes a stationary bike and a treadmill, which retail at roughly $2k and $4k respectively. The gross margin on their combined physical products seems to be 43%, which is similar to Apple’s average gross margins back in 2011-2012 when the company was mainly a device manufacturer and the iPhone was at the height of its popularity.

At this point, it’s worth asking how many people can or will pay such exorbitant prices for Peloton’s shiny collection? According to the company’s S-1 filing, their serviceable market in the United States, the United Kingdom, Canada, and Germany is 14 million people. However, I believe a more reasonable way to measure the serviceable market is to see how many people already pay close to Peloton’s monthly cost of ownership+membership for their boutique gym membership.

So, if you bought a Peloton bike through their financing program and signed up for the associated membership plan, you’d be paying $100 a month total. Meanwhile, the average SoulCycle class costs $42 per session, and by the looks of it Peloton passed SoulCycle’s membership number only last year. Peloton says it currently has over 1.4 million members.

Not only does Peloton cost less than a SoulCycle or roughly the same as boutique gyms like Equinox, it also eliminates the physical limitations, overheads, and lack of scalability gym locations while retaining the personal trainer attention and community feel of live classes. So that 14 million global target certainly seems possible.

Source: Soul Hypercyle and the Wave of New Fitness Boutiques

Meanwhile, the company’s retention numbers are higher than most of the fitness industry - 95% vs. the average 75.9%. “It’s borderline addictive,” said one Peloton member to the BBC recently.

Source: The Verge

Just to augment its income streams further, Peloton also offers a standalone app that costs $19.95 per month for users who don’t want to buy the company’s expensive gear but still want access to the live classes. For comparison, indoor cycling app Zwift, which costs $14.99 a month, had nearly half a million global subscribers last year. In other words, Peloton could double its subscriber base through its app service alone.

Valuation

Peloton’s valuation boils down to a few factors - substantial gross margins, subscriber retention and eventual profitability.

Over the past fiscal year, the company generated $915 million in revenue, of which products sales contributed 78.5% and subscriptions contributed the rest. Both product sales and subscriptions had similar gross margins (42.9% and 42.7% respectively) and were growing at a jaw-dropping clip (106% and 126% respectively, year-on-year). Average revenue per user (ARPU) is currently $129 a year.

Let’s assume that the company’s subscription revenue grows at an annual rate of 30%, while product sales grow at an annual rate of 20%, over the next five years. This would imply that the company’s subscriber base has reached 5.2 million and total sales have crossed $2.46 billion in fiscal 2024.

Applying a 5x price-to-sales ratio, which is on par with a mature company with mediocre margins, Peloton’s valuation in 2024 could be $12.3 billion. Discounting that back to present value at a discount rate of 15% (which seems justified for the level of risk), would place the company’s current value at $6.12 billion.

The company’s current market cap hovers around $6.44 billion. In other words, if you think any of the assumptions above are practical, the company is fairly valued at the moment. If you think my assumptions are overly pessimistic and Peloton can deliver better growth rates, newer products or command a higher multiple in the near future, then this might be a great time to buy the stock.

Source: Twitter

Final Thoughts

By combining recurring revenues, brand appeal, network effects and convenience, the company has found the perfect mix to beat the odds and create a successful fitness technology business.

In other words, Peloton isn’t just a tech hardware company. It’s the most efficient fitness studio on the planet, because it comes to you and stays there forever. Meanwhile, the current valuation seems fair at the moment.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.